Profitability is back in fashion for investors

Stock markets are often driven by a dominant investment fashion or theme. In the period up to the first quarter of last year the focus centred on the apparently never-ending growth opportunities presented by companies in the technology, media and telecom (TMT) sectors. However, a year of unremitting share price declines has firmly nailed the lid on that particular coffin.

Since the turn of this year the focus has shifted to corporate earnings. Indeed, analysts and investors seem to be reacting in an almost frenzied fashion to corporate statements concerning prospects for corporate profitability. For several months, profit statements that surprised on the downside have led to virtually instantaneous and often sharp falls in the respective companies share prices.

More recently, some companies have produced profits that were better or not as bad as revised expectations. Where this has occurred, the market has at least behaved symmetrically by marking up the share prices of such companies.

It is somewhat ironic that the markets are now putting so much store in actual profits considering that, during the TMT share price boom, companies with substantial losses were afforded extremely high share prices. The promise of future profitability seemed to be enough to ignite a surge in almost any company's share price as long as it was in the TMT sector. Now, a stream of visible and real profits is a prerequisite for a strong share price.

This sharp decline in corporate profitability is a direct result of the general slowdown in global economic growth. As recently as six months ago, consensus forecasts for economic growth this year in the US were around 4 per cent and 3-3.5 per cent for Europe. Associated with these forecasts were expectations of corporate profits growth significantly in excess of 10 per cent in both regions.

The deterioration in the US economy over recent months has led forecasters to sharply reduce their estimate of economic growth and corporate profits growth. At economic turning points, such as the current one, forecasts are prone to regular and often dramatic revisions. The table summarises the current broad position for the US, Europe and the Republic.

Economic growth in the US is now forecast to average 2 per cent during 2001 - well below the estimate of US trend growth of between 3-4 per cent per annum. European growth forecasts have been revised down modestly to 2.5 per cent and even the Republic's economic growth has not been immune, with some estimates of economic growth now at 6 per cent for 2001.

If these rates of economic growth prove to be accurate, then the current slowdown does not present a major problem for the global economy and stock markets. The danger is that growth could turn out to be much slower than anticipated. In this regard, the risk to forecasts still seem to be firmly on the downside. The surprise half-point cut in the US Federal Reserve funds rate last week merely serves to provide official confirmation of this.

Therefore, the eventual outturn for 2001 could result in a significant decline in corporate profits in both the US and Europe. Given the more defensive nature of the Republic's stock market and economic growth still significantly in excess of the international average, corporate profits may still manage some modest growth even if the US does go into recession this year.

With price-earnings ratios still at historically high levels in most of the world's stock markets, share prices are not demonstrably cheap. Therefore, any further downward revisions to the forecast growth in corporate profits will act to exert downward pressure on share prices.